Ensuring Compensation Committees Understand the Impact of the Excise Tax on Provider and Executive Compensation

Abstract

The tax law changes that Congress enacted and the President signed into law in late December 2017 included a new employer-paid excise tax that applies to annual compensation above $1 million provided to certain of the highest paid employees of most tax-exempt organizations. The excise tax may also apply to severance paid to a broader group of employees. The law requires these organizations—and as a result, their boards or compensation committees—to understand the basics of the law as well as the process by which executives and employees are identified and their compensation and severance is reviewed. This article discusses the key concepts of the excise tax and helps guide committees on the steps in the process that committees should take, so that they are in a position to understand if—and when—the excise tax could apply.

Keywords

Section 4960 excise tax executive compensation provider compensation

By now, not-for-profit health care provider organizations are aware of the new 21% excise tax on executive compensation, which was implemented as part of the legislation known as the “Tax Cuts and Jobs Act of 2017.”

Specifically, Section 4960 of the Internal Revenue Code (IRC) imposes an excise tax on tax-exempt organization executive compensation equal to 21% of (1) “remuneration” (other than any “excess parachute payment”) in excess of $1 million paid to a “covered employee” by an “applicable tax-exempt organization” for a tax year, plus (2) any excess parachute payment paid by an applicable tax-exempt organization to a covered employee other than an employee who is not highly compensated. This provision imposes the 21% excise tax on an excess parachute payment, even if the covered employee’s total remuneration does not exceed the $1 million threshold amount. The $1 million threshold is not adjusted for inflation.

Hospitals, health systems, provider groups and other organizations that claim exemption from federal income taxes under IRC Section 501 are developing compensation and benefits strategies to mitigate their exposure to the new excise tax. However, compensation paid to physicians and other medical professionals has not received as much attention as has that of their executive counterparts.

Provider Compensation: What Should We Know About the Excise Tax in Relation to This Compensation?

As noted above, this new rule means that annual compensation of more than $1 million, and certain severance payments, are now subject to the excise tax. An important carve-out to the legislation excludes compensation attributable to the provision of medical services by a licensed medical professional when determining this annual compensation amount for each employee. For example, compensation paid to a physician who spends the entirety of his or her time in a clinical capacity—seeing patients and providing other medical services—is not counted toward the $1 million threshold and is not subject to the excise tax.

However, compensation paid to licensed medical professionals who hold dual roles (e.g., 50% administrative and 50% clinical) needs to be examined in the context of the excise tax: depending on the amount of nonclinical compensation that is paid and whether the recipient is in the “top 5 group” (see the discussion, below), the compensation attributable to administrative time could be subject to the excise tax if the recipient’s total annual, nonclinical “remuneration” exceeds $1 million (and/or includes severance payments that would be considered “excess parachute payments” under the rules). This becomes more of a potential issue as a licensed medical professional’s role becomes increasingly administrative and less clinically focused.

Why Is This Important?

Depending on the size of the organization, the number of employed medical professionals and the types of positions held by those professionals, this new IRC provision may result in additional tax liability, unforeseen IRS reporting requirements and recurring tax obligations. If the compensation committee is responsible for the ultimate approval of executive and physician compensation programs, the committee should be aware of not only this new tax but also understand how senior management is to determine whose compensation is potentially subject to the tax, including “dual-role” medical professionals. An organization may employ few or many medical professionals who hold administrative roles, but regardless of the number, the board should have a solid understanding of who is in the group that may be subject to the excise tax, how that was determined, the degree to which compensation is subject to the excise tax and what strategies can be considered to mitigate or eliminate the excise tax on a go-forward basis.

What Should a Committee Do About It?

Specifically, compensation committees need to identify medical professionals whose compensation may be subject to this tax, and fully understand to what extent their compensation is related to administrative duties, as opposed to the delivery of medical services. These tasks can be daunting for the committee to undertake on their own; however, folding in the identification and dissection of compensation paid to medical professionals under these new rules should become part of the annual compensation review process.

Executive Compensation: A Few Key Concepts in Applying the New Excise Tax

Top 5 Group Versus Disqualified Persons

Committees are typically charged with overseeing the executive compensation program as it applies to the “disqualified persons” of the organization. This term has been part of the “intermediate sanctions” rules under IRC Section 4958 for over 20 years. Now committees need to be aware of both who is a disqualified person and who is in the “top 5 group” under the new excise tax rules. These may have overlapping members but are likely not the same, and in any event, need to be confirmed each year as part of the annual review of the program. Below are the key differences between the two:

Disqualified persons (DQPs)	Covered employees (“Top 5” group)
Every Year: Chief Executive Officer (or equivalent) and Chief Financial Officer (or equivalent) is always a DQP	First Year excise tax applies: Must examine all employees to determine who is five-highest paid
Every Year: Need to examine all other senior executives (and influential providers) to identify who is DQP	Every Year after First Year: Any individual who was in the Top 5 group in a prior year is in this group for every year thereafter; need to examine all other highly paid individuals to determine if new additions to the group are required
No limit on the number of DQPs: Depends on the organizational structure and application of detailed regulations	No limit on the number in the Top 5 group after the First Year; once in the group, always in the group
Individual is subject to intermediate sanctions rules for each year is DQP—must confirm that annual compensation is reasonable (i.e., does not result in “excess benefit transaction”)	If in the Top 5 group, “remuneration” must exceed $1 million to be subject to excise tax—must be examined each year—excise tax may not apply each year
Severance payments need to be examined under intermediate sanctions rules to confirm not excessive and result in excess benefit transaction	Severance payments need to be examined in year of payment to determine whether excise tax is applicable

Although there are similarities between the two concepts, committees need to consider the determination of who is a disqualified person and who is in the Top 5 group as separate exercises. The Internal Revenue Service and Treasury Department recently made clear that there is no presumption that if the excise tax applies, that compensation in excess of $1 million is in any way excessive or unreasonable. In other words, like the determination of who is a disqualified person and who is in the Top 5 group, the determinations of whether the excise tax applies and the reasonableness of compensation are two separate exercises.

Remuneration: What Is It?

Remuneration is what is used to determine who is in the Top 5 group. A couple of key points on this item.

First, as a general matter, remuneration is everything that an employee receives for services rendered to the “employer,” with only a few narrow exceptions. (One of the exceptions is any compensation that is paid to licensed medical professionals for providing medical services.)

Second, remuneration paid by related organizations for the services rendered by the employee to an organization subject to the excise tax provision is included in the total. Also, all remuneration paid for services rendered to an organization subject to the excise tax provision must be treated as remuneration, even if one of the paying organizations is not related to the employer of the covered employee.

Severance Payments

Severance paid to an employee who is in the Top 5 group must be examined under the excise tax rules. These are complicated and not easily applied but can result in an excise tax in circumstances that would not be immediately apparent.

Why Is This Important?

The excise tax is new and the rules on how to determine whether it applies are still being developed; however, committees need to understand the basics of the tax and have a plan to address its potential immediate and future application. This only adds to an already full plate that committees are dealing with.

What Should a Committee Do About It?

Committees should have a plan and a process for how the excise tax issues will be addressed. The key steps that a committee should take involve identifying

Who pays the employees (which may be more than one entity)

What is the total remuneration that is paid to these employees

What are the potential severance obligations and whether they would result in an excise tax

What is the exposure to the excise tax for “regular” compensation

What can be done to minimize or eliminate the tax on a go-forward basis

Conclusion

The excise tax on compensation in excess of $1 million is both a challenge and an opportunity for tax-exempt organizations. It is a challenge because it will add to the compensation expense of the organization, and even if it is not applicable today, it may become applicable in the future because the $1 million threshold is not indexed to inflation. In addition, for larger organizations the number of covered employees will likely increase to more than five over time.

It is an opportunity in the sense that it should prompt all tax-exempt organizations to examine their compensation philosophies and programs to confirm their viability and appropriateness, and to consider whether any changes to their composition are in order, which can, among other things, address this excise tax challenge.

Footnotes

Declaration of Conflicting Interests

The authors declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The authors received no financial support for the research, authorship, and/or publication of this article.

Author Biographies

James M. Otto received his JD from the Ohio State University Moritz College of Law. His expertise is in the areas of executive and physician compensation. He has consulted in all aspects of compensation-related projects, as well as overseeing other human resource projects involving benefits, performance management and transaction-driven services.

Thomas P. Flannery has a PhD from Northwestern University and has been a leading writer and thought leader in compensation and benefits. He has published numerous articles and books on rewards, organizational development, leadership and governance. He is a noted expert in tax exempt organizations.